Bond investing seems safe, but it carries its own risks

For most of the past 30 years, conservative investors have been able to get a reasonable rate of return on perceived "safe" investment vehicles such as certificates of deposit (CDs), U.S. Treasury issues or corporate bonds. While the return may not have been as good over the long term as other investments such as stocks, at least the saver didn't have to lose sleep over "risk."

Unfortunately, a false sense of the "safety" of bonds has led many to be shocked by the rise in interest rates in the last two months. Suddenly losses are appearing on monthly statements of what were thought to be safe, conservative accounts. The complacency of the last 30 years of bond investing must be replaced by a new vigilance, so keep these three risks of bond investing in mind.

Risk one: Interest rates

Bond values move the opposite direction of interest rates. Just like a teeter-totter, when one side goes up the other falls. As interest rates move back up to more normal, historic levels (and this may take years) there will be more risk of loss. When this happens, bonds with the most years to maturity and bond mutual funds or exchange traded funds (ETFs) with the highest duration will lose the most. If you don't already know it, be sure to ask your adviser to calculate the duration of your bond holdings. The higher the duration, the higher the risk.

Risk two: Inflation

The risk of future inflation is fueled by the printing press activity of the Federal Reserve and other central bankers around the globe. Inflation at the moment is at very low levels, but won't stay down forever. Anyone locking in today's low interest rates is at serious risk of having future price increases erode their purchasing power, meaning you won't be able to buy as much with your money.

Risk three: Default

One word captures this risk today: Detroit. Default occurs when a corporation or municipality reaches a point where it can no longer meet its interest payments. It's the equivalent of a homeowner being unable to make his or her mortgage or credit card payment. We saw it in Cleveland in the late 1970s and we're starting to see it again as more municipalities reach their financial breaking point. "Muni bonds," as these bonds sold by municipalities are called, have long been thought to be a safe haven because they were backed by the taxing power of the municipality. If you're holding individual bonds, make sure you understand the financial situation of the issuer. It may have changed drastically since you bought.

What to do

If you're a conservative investor, recognize that your definition of "safety" learned over the past 30 years needs to be reconsidered. During that time, bond prices have generally trended upward as interest rates have generally trended down. This can be an unsettling time for longtime bond investors, and we're not saying you should abandon your bonds.

Think of it as hitting a little turbulence in flight. The pilot says, "Fasten your seat belts." He or she doesn't say "reach for the parachutes."

We are saying you should understand all of the risks and recognize that there is no such thing as a "risk free" investment. When you hear that glowing pitch for products like index annuities, the well-trained salesperson often is offering to help you avoid a risk you can see (the potential of falling bond prices, for example) while handing you a contract full of risk you don't see (such as inflation.)

If you're trying to avoid risk, we believe you're actually taking on the most risk when you get into a room with a fast-talking annuity salesperson who says signing this or that particular long-term contract will solve all your problems. In those cases, we say get a second opinion, and get it from someone who isn't about to get a hefty commission from the marketing department based on your signature.

Adding equities

In our opinion, a more reasoned approach going forward is to appreciate that interest rates have nowhere to go but up - not tomorrow morning and not next week, but certainly over the next eight, 10 or 15 years. You'll benefit from shifting your diversification approach to include equities, especially if you have a time horizon of 10 or more years.

The same strengthening economy that is putting upward pressure on interest rates (and downward pressure on bond prices) should be a positive for stocks as business activity accelerates.

To be clear, this is not a "dump your bonds" message. It is, however, a message to seek what we'll call "the new safety" - a well-diversified, tactically allocated portfolio that recognizes, and can appropriately react to, shifts in our transitioning economy to help you reach your secure financial future. ⬛